How Mortgage Lenders Calculate Self-Employment Income

You can get approved for a mortgage if you’re self-employed

Documenting self-employed income is more complicated than for salaried employees.

That’s because calculating self-employed income requires looking through dozens or even hundreds of pages of tax returns, not just two simple pay stubs.

But knowing how to calculate self-employed income for mortgage loans will put you in a better position to provide the necessary documentation, and get approved more easily.

How to calculate self-employed income for mortgage loans

In calculating your income from self-employment, lenders use your net business income and not your gross sales or revenues before business expense deductions.

This is an inherent problem for self-employed borrowers. Most people want to pay less taxes. So, they maximize write-offs (business expenses). But that means they have lower “on-paper” income with which to qualify for a mortgage.

If you plan to get a mortgage in the next two or three years, be mindful of how much you write off.

Lenders will add non-cash expenses like depreciation and amortization to your net income. However, they won’t add back deductions taken for cellphones, internet, or business travel.

The lender will also average your self-employment income. For example, if your net self-employment income in 2021 was $50,000, and $70,000 for 2022, they will recognize your income to be $60,000, or $5,000 per month

This is calculated as follows:

$50,000 (2021) + $70,000 (2022) = $120,000 divided by 24 months = $5,000 per month

Beware of declining income

There can be complications if your income is declining. If your 2021 net income from self-employment was $70,000, and $50,000 for 2022, the lender wouldn’t average your income over 24 months. Instead, they’ll recognize only your 2022 income of $50,000, and average it over just 12 months. That will produce a monthly qualifying income of just $4,166 per month ($50,000 divided by 12).

The lender will use the lower income because your business is showing a pattern of declining earnings.

But that’s the optimistic outcome. A lender may reject your self-employment income entirely if they determine that the declining trend might lead to your business failing.

Extraordinary, one-time events for self-employed borrowers

Fortunately, underwriters take into consideration the effect of extraordinary, one-time events on your income. For instance, if you owned a restaurant in 2020 during the pandemic, your income that year was obviously lower.

Lenders look at this type of event as an external shock that is not likely to repeat and give you the benefit of the doubt when calculating your income. In the above example, the lender may take your 2021 restaurant income as more representative of ongoing performance.

How to calculate K-1 income for a mortgage

K1 income calculation summary

Add lines 1 , 2, 3, and 4C to arrive at income received from the business.

Longer answer

Line 1 (Business income or loss)

+ Line 2 (Net rental real estate income or loss)

+ Line 3 (Other net rental income or loss)

+ Line 4c (Total guaranteed payments)

Besides showing income received from the business, a K-1 is important because it shows the lender how much ownership interest you have in the company. If more than 25%, you are considered self-employed and will need to supply personal and business tax returns.

According to Fannie Mae, “Ordinary income, net rental real estate income, and other net rental income reported on Schedule K-1 may be included in the borrower’s cash flow.”

However, Fannie Mae follows this statement requesting that lenders verify that the business is in a solid enough financial position to be making these payments:

• If you have two years of history receiving “guaranteed payments to the partner”, these funds can be added to qualifying income.
• If the K-1 reflects documented, stable distributions that are consistent with the level of business income, no further proof of business liquidity is required.
• If no distribution history is on the K-1, the lender must analyze the business returns to ensure it has the financial capacity to pay out distributions going forward.

For example, if you receive $50,000 per year from a business making $25,000, the lender will probably not allow you to claim this as real income, as it’s unsustainable.

If you are getting a USDA loan, FHA loan, or VA loan, the lender may not require proof of business liquidity to use this income.

When in doubt, send your full tax return records for the previous two years to a loan officer for review.

Related: Bank Statement Loans For Self-Employed Borrowers

How long must you be self-employed?

The general rule is that you need to be self-employed for at least 24 months. Lenders will look to document this history through a variety of sources, including two years’ income tax returns, a letter from your CPA, or a copy of a business license.

The reason for the two-year requirement is that lenders view income from self-employment as less predictable than for salaried borrowers. New businesses often fail. A person who has two years under their belt is less likely to fail than someone who is brand new to owning their own business.

They will then average your income over that two-year period.

Self-employment less than 2 years

Lenders may accept shorter time frames, though. They may consider income if you have been self-employed for between 12 and 24 months, but never less than 12 months.

New programs cater to those who have been self-employed just one year.

• Self-employed mortgage programs
• Refi, Cash-Out Refi, and Purchase
• Primary, Second, Investment Homes
• No tax returns

Get Qualified

For conventional loans, borrowers with between 12 and 24 months’ history will provide their most recent income tax return, clearly demonstrating that they have received self-employment income for the entire 12 months covered by the return.

The lender will also verify employment over the previous 24 months and make sure you didn’t change career fields when you went self-employed.

You need to have one or, preferably, more years in the same line of work prior to starting your own business.

For instance, someone who was a staff writer at a news agency, but then started as a freelance writer, may be approved for a mortgage with solid income history before and after the transition.

FHA loans are the most lenient traditional loans for those with less than two years’ self-employment history.

Documentation requirements for the self-employed

Expect to provide at least your most recent income tax return, and very possibly your returns for the past two years. The lender’s automated underwriting system will determine whether you need one or two years’ tax returns; there’s no way to predict what you will need until you apply and the lender runs the scenario through the system.

You also may need business tax returns if your business is a partnership, a corporation, and “S” corporation or an LLC.

Any tax returns required must be signed and complete with all schedules included.

The lender may waive the business tax return requirement if the following apply:

• You’re using your own personal funds – and no funds from your business – to cover the down payment and closing costs
• You’ve been self-employed in the same business for at least five years
• Your individual income taxes show a pattern of steady increases in your income from self-employment over the past two years.

Special note about the 4506-T

Lenders require that you sign an IRS Form 4506-T, Request for Transcript of Tax Return. This form will be used to obtain copies of the tax information you have on file with the IRS. Lenders are confirming that the tax returns you’re using for qualification match those filed with the IRS. This is an effort to prevent the use of fraudulent income tax returns so be aware that you may face unpleasant consequences if the IRS transcripts don’t support those tax returns.

Sometimes people re-file taxes. In this case, give your lender the re-filed returns, because your previous returns won’t match the IRS tax transcripts.

Lenders typically can’t use the 4506-T in lieu of tax returns. Its purpose it to verify what you’ve submitted.

Using business assets for the down payment on the new home

If you are withdrawing money from your business to cover your down payment or closing costs, the lender will have to evaluate the effect of that withdrawal on your business.

For example, the lender may request verification of all of your business’s financial assets to assess the impact of the withdrawal. The determination will be different in each case. For example, if your business has $100,000 in cash assets, and you need to withdraw $10,000, it may not be an issue. But withdrawing $80,000 could compromise the survival of your business.

In that situation, the lender will likely request a written opinion from your CPA on the effect of the withdrawal on the business. If the CPA indicates that the withdrawal won’t hurt the business, the lender may allow the withdrawal. But the lender may put the loan approval on hold if the CPA indicates any concerns, or refuses to comment.

If you’re self-employed, it’s important to provide the necessary documentation and to do so as early in the loan process as possible. The lender isn’t looking to hassle you or to decline your loan. But they will need your help in supporting their decision to approve your loan. You’re helping your own cause by being fully prepared to cooperate.

Getting approved as a self-employed person

Lenders approve self-employed people for mortgages every day. There’s no reason to fear applying. The worst-case scenario is that you find out what areas you need to work on to be approved.

• Self-employed mortgage programs
• Refi, Cash-Out Refi, and Purchase
• Primary, Second, Investment Homes
• No tax returns

Get Qualified